Why should you invest in startups?

There are several reasons why people are attracted to investing in startups. First, there is the allure of financial returns. Unlike the returns in the public markets, which are measured in meager percentage points, business angels talk about multiples – which means how many times you get your investment back, which can be 10x or even more. Then, there lies satisfaction in learning about emerging technologies and new business models way before mainstream investors hear about a “trend” packaged in thematic funds. Furthermore, investors like helping young entrepreneurs realize their ambitions, especially if they want to tackle society’s biggest problems. Read the experience of one of our investors.

Attractive financial returns

The average financial returns of startup investing are higher than those from public equity markets. Over a 20 years time span, venture capital returned 11% annually (net of fees and carried interest) versus 7.5% for listed equities, according to Cambridge Associates. Now, these figures are past returns, and they’re taking only the US into consideration. But a general outperformance of private markets compared to public ones intuitively makes sense since venture capital is a more illiquid (you’re not able to sell your investments whenever you want) and riskier asset class than equities. For this reason, investors are expecting higher returns from venture capital. Otherwise, they wouldn’t bother.

What the average return figure hides is a big difference between the best and the worst funds in the sample. Looking at the funds that started in 1997, for example, the best 25% of them returned an astonishing 64% annually on average, while the worst 25% were a failure. They lost 1% every year. The reason for this discrepancy is that a large part of the returns in venture capital stems from backing the rare companies that produce outsized returns. The returns from venture capital follow a power law curve, which means that the bulk of returns are produced by just a few companies. According to VC firm Andreessen Horowitz, 6% of the investments made between 1985 and 2014 account for 60% of the returns. If a fund doesn’t pick such a star startup, its performance will be lackluster at best.

Now, most private investors don’t have access to venture capital funds anyway because they lack the very large investment sums (usually a million or more) to get into these funds. But there are opportunities for private investors to make direct investments in startups, be it through business angel networks, micro funds with smaller entry tickets, or investment networks like Verve Ventures. Do you want to know more in detail about what sets Verve Ventures apart from a business angel club or a VC fund? Take a look here.

Diversification and why it matters

One lesson that the return distribution in VC teaches is to build a diversified portfolio – the chance of backing a startup that will be a highflier is lower with just one or two investments than with 10 or more. However, it’s also important to have some quality standards and only invest in high-potential candidates. Just adding more investments of doubtful quality isn’t diversification, it’s “diworsification”. You can read more on building a diversified portfolio in this article.

Some investors see startups as a way to diversify because the returns from startups aren’t closely correlated to those from the public markets. Others might find the valuations of the public markets becoming increasingly hard to justify. They turn to startups to find high-growth companies at more attractive valuations. Startup investing also offers the rare opportunity to achieve outsized returns that are less common in public markets and measured by multiples instead of meager percentage points. Furthermore, with companies staying private for longer and the number of listed companies in a decline, investing in private companies before they go public is a logical next step from an investor view.

But it’s safe to assume (and this assumption rests on hundreds of investor onboarding calls we did) that many people are driven to investing in startups not just because they expect a return premium over listed companies, but for non-financial benefits as well, even if the possible financial returns remain their main driver. What are these benefits?

Education included

Whenever we organize an investor meeting, an hour is usually not enough to answer all the questions. Investors want to know more about the product, the competition, the business model and numerous other points. People who invest in startups are very curious to learn more about new things, and startup investing is a very rewarding learning setup.

It can be argued that this curiosity is rewarded even more when investing in high-tech startups since these are pushing the limits of what is technically possible. Just to understand the basics of the problem a high-tech startup is solving, and the solution it is proposing requires a mental effort. While poring over some technical presentation might sound like an awful use of free time for some people, for naturally curious persons it is a reward in itself to stay on top of technical developments.

The education that the process of startup investing offers isn’t purely technical, however, it also pertains to the field of business and law. While interacting with startups, the investor will time and again be confronted with questions of building and expanding an organization, sales processes, regulatory hurdles, competition, and other aspects of business life.

Startup investing arguably creates an environment that is more rewarding for curious people

Now, it can be said that there is a lot to be learned from analyzing listed equities as well, in all of the aspects mentioned above. And it is true. But startup investing arguably creates an environment that is more rewarding for curious people. First, startups lack the organizational complexity that defines and burdens multinational companies. This means that it is easier to gauge what is going on in a startup, and where it is heading. Second, startups are working on technologies that are usually years ahead of becoming mainstream and known to the wider public when they are packaged into “investment trend” products. And third, it is possible to have direct access to a startup’s founders, who will, within reasonable limits, be happy and proud to explain what they do.

Talking to the CEO of a listed company isn’t that easy. The investors are usually talking to a relationship manager at a bank, who in turn might speak to a fund manager or analyst who has regular contact with the management of the said company.

In the case of passive investment products such as ETFs, many investors will not even know what the underlying companies are or what they do. While this form of investing has its merits, it strips away all the excitement and the struggle of the business world. In terms of “investainment”, startup investing offers more raw emotion and ambition, more direct exposure to the ups and downs of capitalism than any other investment. “I prefer to attend a startup pitch to going to the cinema”, one investor once confided in me.

What problem?

Investment decisions are silent statements of individual investors about what they think will have a prosperous future. They can be broad and encompass entire countries or be very specific and include just handpicked companies. They can also be negative in the sense of not investing in specific areas out of moral reasons. However, the impact of a single investor’s decision to invest in a specific listed company or not is negligible, and even larger institutional investors struggle to change the direction of companies they’re invested in.

With startups, the picture is very different. At an early stage, every single decision to invest or not makes a big difference, it can even tip the scale between a project continuing or grinding to a halt. These decisions have an impact on which technological avenues will get explored with priority. It is each and everyone’s prerequisite to express through their investment which problems they deem worthy of solving.

From an investor’s perspective, making this possible, and seeing one’s own contribution to the next step in the development of a company gives a sense of importance that buying shares of a big company can never convey. At the same time, the bond is stronger. To put money in a young company, the investors need a much higher conviction than to put it into a multinational with a stable and profitable business. So it is not just a problem that investors deem worth solving and a solution that appears elegant, it is also specific persons that investors are willing to back because they see their potential and their drive. Observing founders pitch their ideas teaches humility because many of them are incredibly gifted, some are good salespeople, and they put in a tremendous amount of hard work to pursue their vision. Dedication and persistence are necessary to succeed. And every once in a while, a person enters the room that cannot be described otherwise than “a natural-born entrepreneur”.

For some, giving other people the means to become entrepreneurs is a very valuable goal in itself. Unsurprisingly, such investors tend to be or have been entrepreneurs themselves and now want to support the next generation of entrepreneurs.

Helpful investors

So far, the emphasis has been on what startups provide as value to the investor. But one of the most interesting aspects of being invested in startups is that the investor can actively contribute to the success of these ventures. This is a unique trait of this asset class.

“Every investor should be a cheerleader”

Helping a startup succeed can take many forms, and which ones investors choose depends primarily on their knowledge and social capital. The most effective way to help is to introduce a startup to potential customers. This makes investors with a background in the same industry highly relevant for startups because they can hopefully open many doors. Startups are also constantly hiring, and people who know a bright potential candidate can play matchmakers in such a situation. Then there is a myriad of organizational questions where investors can help just by lending their expertise or opinion on a certain topic.

Finally, “every investor should be a cheerleader” as one investor once told me, and in the age of social media, it doesn’t take much to help get a startup’s message out to the world by helping to spread it. In this interview, an investor from the Verve Ventures network explains why investing in startups is a memorable experience.

Many rewards await

Having a diversified stock portfolio makes sense from a financial perspective. Building a diversified startup portfolio is financially even more promising, but also more rewarding in many other aspects. It will bring you in contact with very bright minds and very interesting startup co-investors. It is a very direct and emotional form of investing that sharpens the understanding of technological advances you won’t read about in the newspaper soon. I’ve learned more about the advances in agricultural robotics, in single-cell technology and the different application of drones from interactions with startups than from some trend reports the big asset managers churn out.

Startup investing also allows making the best use of one’s own professional skills and connections to foster the development of a startup and increase its chances of success. Committing capital to solve important problems can be an end in itself, as can be fostering entrepreneurship. It is, however, also an incredibly slow form of investing. It takes a lot of time to identify promising startups and then again, to see them mature. It also takes a big leap of faith to do one’s first investment. For those who’ve never done it before, as well as for those who want to broaden their deal flow, Verve Ventures offers access to financing round with all the necessary documentation in place, a good place where to start and learn about startup investments. Watch this video to find out how we select the best startups.